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Capitalizing on ETF Price Wars

The asset management industry is experiencing dramatic change. In 2010, the universe of exchange traded products (ETPs) experienced its own big bang. ETFs have proliferated to the point where there isn't an asset class, a strategy, or country that isn't tracked in one form or another by an ETP. (See table, page 44.) It's confusing to retail investors, for sure, and it adds extra burden on advisors who must research and learn about them all.

Despite the increased research work, 2011 will bring a nice dividend in the form of reduced prices. The increased competition has led to something of a price war among ETF providers. Meanwhile, within the last year, the effects have been seeping into the mutual fund world, as traditional active asset managers struggle to compete against their low-cost ETF rivals. (That said, mutual funds have been around since 1926, and they obviously still represent a sensible vehicle for retail investors to gain exposure to different asset classes. That is, if you can find a cheap one that adds alpha.)

Lowering Costs For Clients

John Knowlton, a financial advisor with Oak Point Financial Group, is capitalizing on this trend. In October 2009, the Michigan-based RIA started using more exchanged-traded funds as well as the lowest-cost share classes of mutual funds. With the shift, the firm's 2010 revenue was up 10 percent over 2009. Even without the 12b-1 revenue, the firm still had a great year, raking in more dollars and referrals from existing clients. The fact that Oak Point is saving its clients money “contributes to a sense of trust, confidence, and a sense that the advisor is putting the client's interest first,” Knowlton says. “I believe this is an opportunity for advisors to get in front of these changes and tell their clients, ‘Hey, I'm doing this for you.’”

Charles Zhang, managing partner and president of Zhang Financial, says his shift to lower-cost investment vehicles has also paid off, with assets under management growing 15 to 20 percent since the change. Zhang also improved his client retention rate, which went from about 95 to 99.5 percent.

“The high-margin, high-profit time for the mutual fund is over,” he says.

Clients of the firm will pay an average expense ratio of about 0.25 percent, compared to about 1.2 percent for the industry average, Zhang says. His average advisory fee is about 1 percent or less, depending on the account size.

As we head into 2011, there's no sign the recent pressure on prices will abate, say industry experts, even if further cuts are small and incremental. Advisors and investors are going to become more aware of the increasing number of investment options available to them, which could result in even more fee compression, says Steve Deutsch, director of separate accounts and collective trusts at Morningstar.

The question becomes, will you position yourself to take advantage of the changing dynamics in asset management after the ball drops? Here's what you need to know about this new reality.

The ETF Front

iShares, which was purchased by BlackRock in June 2009 as part of its acquisition of Barclays Global Investors, has been the market leader in the exchanged-traded funds space for much of the past decade, and it still holds first place. (See table, page 44.) But in November 2009, Charles Schwab burst onto the ETF scene, a move that shook up the prevailing order and altered the asset management industry at large. Lots of investors wanted to talk to Chuck. Why? Lower fees. That fall, Schwab launched four funds with fees well below market rates, undercutting some of the biggest players in the space, including iShares, Vanguard and State Street Global Advisors. The price war was in full swing.

While iShares has been the biggest player, with the most assets and share of the market, Vanguard and other competitors are catching up. (See table.) According to Michael Johnston, senior analyst at ETFdb.com, there are many new exotic and complex products popping up, such as Van Eck Global's Vietnam ETF (VNM) or Emerging Global's Emerging Markets Consumer Titans Index Fund (ECON), and the amount of choice in the marketplace is forcing funds with a broader mandate to try to differentiate themselves. Unlike mutual funds that try to beat a benchmark, ETFs are often trying to replicate an index — however loosely defined sometimes. They can't always compete on performance, so they compete on expenses, Johnston says.

For ETFs, the average expense ratio has remained at 0.56 percent for both 2009 and 2010, but ETF providers have been recently slashing fees. The average expense ratio has not fallen because there are still some expensive ETFs, such as active ETFs, leveraged ETFs and the more exotic funds, and some of the newest, low-cost funds are still gaining traction, says Robert Goldsborough, ETF analyst at Morningstar.

The Writing on the Wall

The growth in the ETF industry has not stopped investors from shelling $242.6 billion into mutual funds over the first 10 months of 2010, according to Morningstar. The total amount now invested is $7.75 trillion. But the price wars on the ETF side have fueled the fire for mutual funds to lower their fees. The average expense ratio for mutual funds has dropped from 1.24 percent in 2009 to 1.23 percent in 2010. (The expense ratio would be lower if you excluded the expensive specialty funds that few people own.) Andrew Gogerty, senior fund analyst at Morningstar, is not surprised the average moved only slightly, as not everyone is cutting their fees, and there is so much money spread out across the entire system.

While a dramatic drop in assets under management in late 2008 and early 2009 put upward pressure on fees in the mutual fund industry, low-cost funds will garner more of the asset flow as investors look to find an attractive value in the recovery, says Gogerty.

Many mutual fund providers are looking to tap a piece of the ETF pie, with firms such as The Hartford, Janus Capital Group, AllianceBernstein, Dreyfus and Legg Mason filing with the SEC to offer actively-managed ETFs. Eaton Vance also moved into the ETF space with its purchase of Managed ETFs, a developer of intellectual property in ETFs.